Larry Summers gives us the bad news. Worse, the only solution is more of the same.

Summary: Larry Summers speech last week was, IMO, a pivotal moment. It forced economists to look at the US from a new perspective, considering things that had been heretical. The previous post, Are we following Japan into an era of slow growth, even stagnation? sketched out his bold speech. Today we look at the text, with the good news (better definition of our problem) and the bad (no new solutions). This post ends with a bang (or warns of a bang, depending on your point of view).

Contents

Prelude: the missing “V” recovery

Summers warns of the great stagnation

We fight a crisis with the theories we have

Bubbles to the rescue

More economists jump into the debate

For More Information

(1) Prelude: the missing “V” recovery

Despite the great economic events of the past five years, economic policy and theory debates have largely run in circles. Pro and con fiscal stimulus. Pro and con monetary stimulus. Forecasts of the “V’ recovery each year; forecasts of slow growth (include me on that team).

One quiet theme has been a few of us warning that we have fallen into a situation like, in its essentials, that of Japan in the quarter-century since their 1989 bust. That’s been declared daft by mainstream economists. Until now. It’s a shattering idea, because Japan shows the intractable nature of this trap. They might have found a solution in “three arrows” of Abenomics (massive monetary AND fiscal stimulus, drastic structural reforms) — but the solution might prove ruinous. Or ineffective Or both.

The speech changed the debate. It deserves your attention.

(2) Larry Summers warns of the great stagnation

Excerpt (lightly edited for clarity) from the transcript of Larry Summers’ speech at the IMF Economic Forum on 8 November 2013, prepared by Randy Fellmy, posted at his Facebook page. Red emphasis added.

It is a central pillar of both classical models and Keynesian models that it is all about fluctuations: fluctuations around the given mean, and that what you need to do is have less volatility. I wonder if a set of older ideas firmly rejected in {graduate monetary economics courses} — that went under the phrase “secular stagnation” — are not profoundly important in understanding Japan’s experience, and {might be relevant} to America’s experience.

… If you study the economy prior to the crisis, there’s something odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody believes that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn’t under any great pressure. Unemployment wasn’t under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.

.

Mr. Bubble, meet Mr. Needle

… So what’s an explanation that would fit these observations?

Suppose that the short-term real interest rate that was consistent with full employment had fallen to negative 2% or negative 3% sometime in the middle of the last decade. Then what would happen? Then even with artificial stimulus to demand coming from all this financial imprudence, you wouldn’t see any excess demand; and even with a relative resumption of normal credit conditions, you’d have a lot of difficulty getting back to full employment.

Yes, it has been demonstrated that panics are terrible, and that monetary policy can contain them when the interest rate is zero. … It has been demonstrated, less conclusively, but presumptively, that when short-term interest rates are zero, monetary policy can affect a constellation of other asset prices in ways that support demand, even when the short-term interest rate can’t be lowered. Just how large that impact is on demand is less clear, but it is there.

But imagine a situation where natural and equilibrium interest rates have fallen significantly below zero. Then conventional macroeconomic thinking leaves us in a very serious problem, because we all agree that, whereas you can keep the Federal funds rate at a low level forever, it’s much harder to do extraordinary measures beyond that forever — but the underlying problem may be there forever. It’s much more difficult to say we only needed deficits during the short interval of the crisis if aggregate demand, if equilibrium interest rates, can’t be achieved given the prevailing rate of inflation.

If this view is at all correct, most of what would be done under the aegis of preventing a future crisis would be counterproductive, because it would in one way or other raise the cost of financial intermediation, and therefore operate to lower the equilibrium interest rate that was necessary.

Now this may all be madness, and I may not have this right at all; but it does seem to me that 4 years after the successful combating of crisis, with really no evidence of growth that is restoring equilibrium, one has to be concerned about a policy agenda that is doing less with monetary policy than has been done before, doing less with fiscal policy than has been done before, and taking steps whose basic purpose is to cause there to be less lending, borrowing and inflated asset prices than there was before.

So my lesson from this crisis is — and my overarching lesson, which I have to say I think the world has under-internalized — is that it is not over until it is over; and that is surely not right now, and cannot be judged relative to the extent of financial panic; and that we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back below their potential.

(3) We fight a crisis with the theories we have

Five years of zero-interest rate policy (ZIRP) and three rounds of quantitative easing have stabilized the economy, so that mainstream economists’ debate the timing of the start and acceleration of normalization — with tapering QE3 being the first step.

Summers warns that this might prove misguided. Perhaps the unconventional monetary policies at work in Japan, Britain, and USA are necessary. Perhaps return to normal growth requires these policies, and the asset price and investment bubbles they create.

Summers did not give detailed recommendions. He assured us that there is a monetary solution, and it is more of the what we’re doing — perhaps even accelerated. Perhaps so, but I doubt it.

Must we choose between stagnation or calamitous bubbles? Being between economic versions of Scylla and Charybdis? We have fallen into a crisis in scientific theory as described by Thomas Kuhn: paradigms cannot be disproved, only replaced. Economists, like generals, must work with what they have — no matter how inadequate — not with better tools of the future.

We need new theories. Stat. Otherwise I doubt this will end well. The demographic tide of the aging developed nations (e.g., the boomers in America) will put immense stress on our economies. Time is not our friend.

(4) Bubbles to the rescue

“The commonest error in politics is sticking to the carcass of dead policies.”
— Lord Salisbury, discussing Great Britain’s policy on the Eastern Question (1877)

Look with wonder at this graph of home affordability (and hence valuation) in terms of the median price to median family income ratio, from the Q3 2013 Quarterly Letter by Jeremy Grantham , chief investment officer of GMO (Grantham Mayo van Otterloo).

Jeremy Grantham’s Quarterly Letter, Q3 2013

Prices are only one standard deviation from the 36 year mean. But that includes the 8 bubble years. Excluding those, and even more if so including earlier data (back to 1970 or 1960), would show the current level as quite extreme.

The median home/income ratio was 3.47 in September 2012 vs the 1976-2000 average of aprox 2.9 and the pre-bubble peak of aprox 3.1. It rose to 4.06 in September 2013. That’s 40% above average and 30% above the previous pre-bubble peak for what was once a stable series. (source)

Fitch Ratings, attempting to avoid repeat of their failures during the past two bubbles, has just published “U.S. RMBS Sustainable Home Price and Economic Risk Factor Special Report” November 2013. Free registration required. Much of their analysis has an optimistic bias. For example, when calculating home affordability they use mean instead of median incomes, and ignore changes in credit availability (high requirements for downpayments and credit scores)

Other asset prices show similar patterns, such as art and farmland. Rising asset prices stimulate the economy. But each cycle of bubble-collapse further distorts its normal operation. I fear this will not end well.

What total nonsense. As if negative interest rates are the magic bullet to end the “Great Stagnation.” This is pure economic drivel akin to alchemy.

There are so many obvious factors that are the real problems, such as the ever skewing unequal distribution of income that has ground down the middle class and led to the over reliance on debt financed consumption, the bloated and corrupt financial sector that distorts the economy, the corporatist culture where “star” CEO’s are only concerned about short term, artificial profits (workers and consumers be damned), the incestuous nature of government where lobbyists, politicians and business all share the same bed (i.e. tax reform and health care), chronic under investment in education and infrastructure, gross over spending on defense including billions down the drain on pointless wars, etc. etc.

Negative interest rates will not solve any of these problems and it is frightening that any serious person would grasp at this straw. I can only guess that after rightfully being run out of consideration for chairmanship of the Fed, Summers wanted to muddy the waters for Yellen and to grab a last bit of attention for himself. Larry Summers’ record in government “service” and as president of Harvard speaks for itself. He was an active accomplice in facilitating many of these real problems plaguing the US economy. By all accounts, he is a disingenuous, egomaniacal chump.

That is a natural reaction. As every science moves from early stages to maturity, the public attitude also evolves — moving from amused tolerance to deference & respect. Economics is at that point where it gets “traction” in its ability to make useful forecasts, and thereby becomes operationally useful to society. Chemistry, physics, medicine all went through this.

At that point people react with incredulity at its claims, made on the the basis of facts and logic unfamiliar to the average person.

Making this transition more difficult, the scientists — heady with their new understanding — often make exaggerated claims about the ability of current and future science.

So while the list of problems you cite is real, their seriousness great, that does not mean that economic tools cannot be effective in their large, vital, but limited sphere.

Also, Larry Summers does not claim that monetary policy is a panacea for the wide range of social challenges that face us. It is just another tool in the box.

I did not dispute that serious, unbiased economic analysis (unfortunately a bit scarce and generally ignored within the DC borders) can help to solve some of the underlying challenges facing the US economy.

But please, the concept of negative interest rates is really off the wall, both in terms of every single school of economic thought and also in terms of common sense. We already have seen many years of ZIRP (zero interest rate policy), do you really think that moving rates to negative will do more good than harm?

Even ZIRP is under criticism for destroying the chances for Amercans to save for a liveable retirement and for incentivizing debt overloads. Moreover, since ZIRP has faced the zero rate boundary, the Fed has provided massive QE (quantitative easing), which has provided some debatable short term benefits to the economy, while at the same time creating some risky asset bubbles.

We have reached the limits for what pure monetary policy can do, if we want to move forward we need to look at creative fiscal policies (ala MMT) and especially major economic and political reforms. It is a huge challenge, particulary in the current political climate, but is doable. Summers’ proposal for negative interest rates is an unhelpful red herring and is especially irritating since he is a person who was a major player in accomodating the the real problems of the US economy.

“please, the concept of negative interest rates is really off the wall, both in terms of every single school of economic thought and also in terms of common sense.”

Please provide some citations to support that.

In fact that statement is quite wrong. It reminds me of people reacting to the concept of negative numbers, or relativistic effects, or evolution. “Can’t be!”

The concept of negative real and even nominal interest rates goes back to the 19th century. One of the best-known early economists working with this was Silvio Gesell (1864-1930).

In the 1930s there was much work on this by economists, such as Irving Fisher and Keynes. In the 1990s this became of widespread concern as Japan fell into a deflationary cycle, with considerable work done on this by well-known academic economists such as Nobel laureate Paul Krugman.

The take-away from this post is that if interest rates go negative, we may see an epochal outburst of socially unproductive—even if individually beneficial—financial innovation. Financial service providers are likely to find their products and services being used in volumes and ways not previously anticipated, and regulators may find that private sector responses to negative interest rates have spawned new risks that are not fully priced by market participants.

“Other asset prices show similar patterns, such as art and farmland. Rising asset prices stimulate the economy. But each cycle of bubble-collapse further distorts its normal operation. I fear this will not end well.”

Silliness.
The first Comment under PK’s article answers it all.
Those of you to young (under 60) to recall real household formation with One Income may be perplexed.
Pay people more $$
Nah…cannot be that simple.

I’m sorry, but your defense of the “science” of economics is pathetic. Economics is mostly ideology; those in power buy the best economist to speak the words they want them to speak. Hence no Fed chief has ever seen a bubble in the past three decades, virtually (“irrational exuberance” being moot), and none has done anything about one. While Yellen sees no bubbles, Establishment-certified analysts like John Hussman certainly do; as well as plenty of practical analysts, people who have to put their money where their mouth is.

The first comment to the Krugman article referenced in another post is apt, reproduced here:

“What has been normalized since about 1980 is a radically altered economy which has assigned virtually all productivity growth, income growth, and wealth gains to a tiny economic elite, centered largely on Wall Street and in America’s boardrooms. Mr. Summers, unfortunately, was one of the architects of the financial de-regulation which led to the 2008 crisis and after-effects. I would not be looking to him for solutions, or to Tim Geithner, who just went through the revolving door to a Wall Street hedge fund operation.

The only answer is to undo, through the political process, an economy largely rigged against those who work for a living, one designed by people who live off of a return on capital, and care about nothing other than preserving and expanding it.Their victims litter the landscape: a disappearing middle class, high unemployment and underemployment, declining living standards for the 90%, a massive increase in poverty, and the worst income inequality since the Gilded Age. Enough already, with government of, by, and for those with enormous unearned wealth. Do something for those who work for a living.”

The US economy is constipated with no healthy flow of income and product because of income inequality, the fecal impaction being the bad debt in the banking system that is causing the flow of blood money to the banks from the Fed. Crony capitalism has fulfilled Marx’s prophesy of the immiseration (getting there) of labor, beginning with Ronnie’s smashing of the air traffic controllers. Labor comp/GDP at record lows, etc.

What is really scary is that the Rockefellerian “Illuminati” dream of a world financial system based on *fiat money central banking* no less, is now close to reality. In this world, the capitalists (the owners and manipulators [management] of capital) will be able to selectively arbitrage labor markets around the world ad infinitum, blowing bubble with debt-inflation and gathering up assets on the cheap when they pull the rug out. Read the history of the formation of the Fed.

Do not refer to economics as a science! We already know the mainstream forecasts are garbage. As commonly practiced it is pure ideology. The next thing we’ll hear is that we need “free markets” to solve our problem, just like the “free market shock therapy” in Russia in the early Nineties that left it a hollowed out, oligarchical, pre-fascist state as state assets were *stolen* (“sold” at trivial prices) by private parties to cancel bad debts. The hedge funds, glutted on Americans’ homes, will go after municipal assets next, bridges and roads and parks and public lands.

Mainstream economics as a handmaiden to the PTB is fully supportive of the march toward neo-feudalism that seems to be the dream of the elites.

Science is an empirical process, at its best subject to proof by demonstration.

In 1929-1932 we had an economic shock. The wrong policy response led to a depression. In 2008 similar conditions occurred — by most metrics it was similar or worse than 1929. But economists had better theories. These were implemented, and a depression was avoided. Q.E.D.

Since then nations following mainstream policies (esp US, UK, and China) have had slow growth. Better than nothing, but reflecting the frontier in economic theory, the low understanding about dynamics of growth — esp under conditions in which total debt near’s the economy’s max carrying capacity.

“In 1929-1932 we had an economic shock. The wrong policy response led to a depression. In 2008 similar conditions occurred — by most metrics it was similar or worse than 1929. But economists had better theories. These were implemented, and a depression was avoided. Q.E.D.”

HA ha ha ha, love the “QED”. experiments performed on two different test subjects can not prove anything. This is not even close to scientific method.

Your analogy is incorrect. The US was the same “test subject” now and then. To use your analogy, these are treatments (not “experiments”) done on the same test subject at ages 153 and 231.

Also, your understanding of the scientific method is limited. Large-scale real world applications are among the most convincing proofs, trumping small-scale tests in the lab. They are not repeatable, except over time (Abenomics is a kind of second trial).

More to the point, I am much more concerned about charts which show that the ratio of median monthly income to median monthly rate in most U.S. cities is now hovering around 85%. This is bizarre and unsustainable. Something has clearly gone badly wrong with the U.S. economy.

There are many signs that something has gone wrong. I cannot think of another period in U.S. history in which inflation ran at below 1.5% but banks were able to charge in excess of 35% interest, as on typical bank-issued credit cards. I cannot think of another period in U.S. history in which students accumulated hundreds of thousands of dollars of college loan debt which they were not permitted by law to discharge in bankruptcy.

These are unprecedented economic conditions. I don’t think they’re sustainable. Something is going to have to change.

Duh!!! Obviously the whole discussion was in terms of nominal negative interest rates being targeted by the Fed. Real rates are negative anytime the rate of inflation is higher than the nominal rate, which has obviously occurred in the past.

The best support is the article that you cited. It traces the history of the idea of negative nominal interest rates from an arcane economic reformer named Gesell through a few musings on the topic by later more well known economists who largely rejected it (From your article, “Indeed, Keynes called Gesell’s theory only ‘half a theory of interest’ (Keynes, 1936, p. 356) because in his opinion Gesell failed to understand the role of uncertainty in determining liquidity preference and hence the rate of interest”) to some more recent work by some economists on highly theoretical models whose practicality and value to the real world are extremely dubious because of the usual need to employ myriad unreal simplifying assumptions.

As far as I know, negative nominal interest rate targetting is not part of the standard policy prescriptions of the neo-classical, Austrian, new Keynsian or post Keynsian schools of economic thought. That being said, I may now possibly stand to be corrected, as just yesterday Bloomberg has mentioned some mutterings about the ECB introducing negative nominal interest rates, although Draghi refused to confirm it and any actual implementation would only be over the dead body of the Bundesbank: Search Results for “ECB negative interest rates”

However, let’s agree to end this discussion about the origins of the advocacy of a policy of negative nominal interest rate targetting by central banks. If anyone thinks negative nominal interest rates are a worthwhile experiment, they are welcome to go ahead and try, but they will likely discover that they not only are not a panacea to the economic ills causing the Great Stagnation, but may rather cause significant harm and even worse to prove to be a distraction from the real issues that need to be confronted. If this idea is Larry Summers’ last contribution to economic policy making, it is a fitting one in terms of his legacy.

(1). Did you notice that Gesell was born in 1864? That might account for Keynes’ “half a theory of interest’”. you discuss shows that you quite missed the point: negative rates have been discussed as a tool for a long time.

(2). “discover that they not only are not a panacea to the economic ills causing the Great Stagnation”

Always a good indicator of a layman who does not understand the science: saying that it “is not a panacea”. No economist calls monetary policy of any kind a “panacea”.

(3). I note you still have provided no citations supporting your statement that “the concept of negative interest rates is really off the wall, both in terms of every single school of economic thought”.

(4). Now you say they are “not part of the standard policy prescriptions of the neo-classical, Austrian, new Keynsian or post Keynsian schools of economic thought.” That is a far narrower claim, but of course correct.

The relevant point is that central banks are using “unconventional policies”, measures that would have been considered mad before the new era that began with Japan’s crash.

*. Krugman was considered daft in the mid-1990s (date from memory) when recommended the BoJ do QE, which they started in 2000.
* QE is still “not part of the standard policy prescriptions” in all “schools of economic thought”.
* It is not over. Nobody knows what will be tried before this cycle ends, if current conditions continue. Perhaps even negative nominal interest rates.

“I think you loose the argument anytime you claim your science is so advanced, a layman can never understand it.”

Neurochemistry? Genetics? Quantum mechanics? Statistics? At their higher levels all of these are incomprehensible to the layman. I have read Science and Nature for decades. After college I understood a fair bit of each issue. Each year I understand less. Read an economics journal to see how much of it you understand?

That must be one of the most foolish statements I have seen in a long time?

Effective negative real interest rates can be attained by increasing inflation by maintaining near-zero interest rates. The U.S. banking system and Treasury department, however, have shown themselves reluctant to increase inflation. To the contrary: both appear to be still targeting inflation as the major danger to the U.S. economy, even though it is clear from the historical data that inflation has not represented a significant factor in the American economy since the mid-1980s at the very latest.

What is really going on here is that very low inflation or deflation is remarkably advantageous to creditors. The U.S. economy now appears to be controlled by creditors (the billionaire top 1% who have amassed vast amount of capital and now lend it out in various ways to the rest of American society), and thus economic and monetary policy is being tilted in their favor.

This is just dumb. Unless you can show some similarity between Venezuela and the US, you are just showing your ignorance of basic economics. The relation of a nation’s currency level and domestic inflation is quite complex.

Also, the value of the US dollar vs. other currencies has risen during QE3: see this Fed graph.

“Did you bother to read the linked article or do you have your snarky post responses pre-prepared?”

Let’s rewind the tape to your statement, which you defend with such obstinance:

“the concept of negative interest rates is really off the wall, both in terms of every single school of economic thought and also in terms of common sense.”

I showed that negative nominal interest rates has been a subject of discussion among the world’s leading economists since the late 19th century, which disproves your statement.

Due to current circumstances — years in the liquidity trap, which was until Japan’s crash considered unlikely or even impossible — it is actively discussed by some of the world’s leading economists and central banks. Denmark’s Central Bank set its official CD rate at -0.2% in July 2012 (see Financial Times). You yourself cited a statement by the head of the ECB that they are talking about it. (see Bloomberg News).

All of this disproves you statement with respect to modern economics.

In rebuttal you cite a blog post by a woman with an MBA, who worked in IT — “writer, singer and twitterer extraordinaire“. It was republished at the Pieria website. She cites no economists; it’s what she thinks about it.

That confirms the conclusion I gave in my previous statement about you. I’ll add a secondary conclusion: this is a waste of time, demonstrating the futility of most internet threads. While not exactly troll-like, your behavior is similar.

Actually she has both academic training and professional experience in finance and risk management. Her detailed comments on the likely futility of central bank negative interest rate targeting are far more real world practical and rigorously insightful than Summer’s off the wall musings in which you have invested so much of your intellectual capital in defending.(talk about negative returns) However, I was surprised to learn from you that only Ivy tower academic economists can speak intelligently about or understand the real nuts and bolts of finance and economics and the more degrees they have the better. KInd of makes you wonder how with them around that the economy ever got into such a dreadful mess?